Archive for the ‘Where the dollar meets the register’ Category

I’ve had the privilege of sitting in on a healthcare innovation class put together by the fabulous Emer Dooley for the University of Washington. The learnings from that class are a whole blog by itself. In talking about healthcare, a quick reference to its significance as an expense is that it’s the 2nd largest single expanse a company has, after payroll. The unpredictability & volatility of it as an expense for self-insured companies is a significant stress point for companies not used to being in the insurance business (The AOL “distressed baby” mishap being an extreme example) but the overall expense is so high that companies as small as 3,000 employees are going self-insured. Net, that means they keep the premiums, they take the risk on the expenses, and they pay an insurance company a small % to handle the administration & billing.

Now to that “single” biggest expense of payroll –if you look at a public financial statement it’s usually there as a lump sum. This is a great example of how financial statements are written for and by accountants. Payroll for small companies is often outsourced to a third party to make sure all the appropriate tax withholdings are done and passed on to the appropriate authorities at the right time. Larger companies may bring that back in as a department. For the company itself, it’s a big expense that happens on a single day, 2-3 times a month. Reconciliation of it is complex because employees can have all kinds of individual variations with deductions, vacations or leaves, new and departing employees. For the accounting department, payroll is a BIG deal. For managing cashflow, payroll is a BIG deal. It needs to be attended to as a thing.

But what a skilled executive/manager should know, is that payroll is not actually a thing in itself. If you’re looking at your expenses, it’s not helpful to look at “payroll”. It represents an agglomeration of many functions of a company – product creation, product validation, sales, distribution, marketing, customer relations. When you’re thinking about how your resources are currently allocated and might be better allocated, you want to think about those categories, and the people/energy going into them, and the effectiveness of those against expectations for their category. If you’re looking to invest more or make cuts, good management needs to focus on those areas of company function, not just on “payroll”.

This is reinforced for me as I listen to Zeynep Ton’s The Good Jobs Strategy. She talks about her work with retail chains facing falling sales and deciding to cut payroll, without doing the analysis to discover that the falling sales were due to poor customer service. Instead of improving profitability, they got into a vicious circle that resulted in store closings. She worked with Borders for 5 years and was able to show that in many cases, increasing payroll actually increased sales. The key there is, again, that payroll is not a thing – it’s a construct made for the accounting department to manage cashflow. What they were really tinkering with was customer service.

If you run one of the many small (and not so small) businesses managing on Quickbooks, congratulations to you if you’ve developed a habit of looking at your P&L on a monthly basis and comparing it to budget and re-projecting your cashflow. Most likely, you have a line item that’s “payroll”, or “wages”. You can start by at least breaking it into sub-categories: marketing, sales, production (hopefully you are already breaking out your direct labor so you can correctly calculate fixed costs vs variable costs), administration, distribution. Things like IT and professional services- if outsourced- will show up somewhere else. Then go ahead and let all the payroll taxes sit as a lump sum because they’re not really discretionary anyway. The key here is to look at your relative investment in the various functions of your business.

If you really want to look at your overall expenses that way, go ahead and move those payroll categories into the various sections of your P&L. Keep them as distinct line items so you can add them back together when you or your bookkeeper are doing bank reconciliation against that transfer to the payroll company. You can leave payroll taxes as a line item under administration or general – they’re less discretionary, they just vary with your payroll. For finer grain detail on the total cost of in-house vs outsourcing you’ll need to consider the payroll taxes. Then a quick glance down your P&L will help you see where the resources of your company go at a high level. Are you investing enough in marketing? Whether it’s outsourced or in-house, whether it’s labor or google ads, how much is it as a % of sales? Are you spending a significant amount on production or service? If that’s the business you’re in, I hope so. If it’s not translating into sales, you can start asking why.

I recently got to work with a small manufacturer who had a multi-week work-in-progress period. This small business was using quickbooks but growing quickly and so often managing more by the level of cash in the bank account than by budget. While I was working with them, the business got the hang of looking at their COGS and their variable costs vs fixed costs and more of an accrual style of reporting. They also shifted to more of a product distribution model which meant longer receivable delays and more planning. I realized that with that supposed “improvement” of business maturity there was a possible loss: that of deliberately funding the increase of inventory to support sales growth.

When operating on more of a cash basis, this business had to use current sales to cover the cost of future growth, because they had to buy inventory this month, and do labor this month, for product that would not be ready until next month (or later). They had started out with a direct-to-consumer model and so sales were entirely cash in the beginning. Since anticipated future sales were higher, they had to figure out how to create that product with the cash they had on hand, because inventory providers were unwilling to provide credit for such a small startup. As they grew as a business and we focused on looking at accrual accounting, it becomes apparent why separately tracking cashflow is so important – because in an accrual presentation, the cash needed to fund the higher investment for higher future sales becomes invisible, each month looks like it can cover itself.

I once had an angel fund investment go south and what we heard back was that somehow in the transition from cash to accrual accounting they had come up a significant amount of money short (maybe 1/3 of the round they had just raised). A funder stepped in a provided it, but at sufficiently punitive terms that our investment became pretty insignificant. The CEO and CFO were replaced, of course, but I had always wondered how that could possibly happen. Now it makes sense to me, that if they had done their financial modeling on an accrual basis and not attended to cashflow, they could have raised a bunch of money for growth and missed how much inventory they’d have to build to support that growth and how far ahead of sales they’d need the cash. It’s also possible that they underestimated how long their cash-conversion-cycle would be: that route from dollar invested in inputs, created into goods, shipped to distributors, sold to customer, and then easily 90 days from shipped-to-distributor until finally returned-to-company.

Another angel I know invested in a homey wood-toy company who got caught by that: the homey wood toys were manufactured in China and required a 6 week boat ride to get to US distribution. Growing sales required also growing an even bigger cycle of toys in the manufacturing/distribution pipeline.

Net: although accrual style accounting is standard for a mature company, you lose important information if you don’t still also do a cash accounting.

It’s a common frustration for small business owners that banks seem only willing to finance companies that don’t need it. It’s pretty standard that to get a bank loan a business has to have multiple consecutive quarters of profitability. That seemed pretty conservative to me, but after a couple years of working with bootstrap small businesses I’m beginning to see why that might be necessary protection.
Bootstrapped startup and young businesses are wonderfully creative in their ability to make-do. As a business grows and generates more resources, it doesn’t become profitable right away. Those early years of business growth end up steadily funding capacity building. As a business has more resources, those resources go not only into growth through marketing, or asset building with equipment and facilities, but professionalization where previously there’s been make-do.
Obvious and common sources of “hidden funding” are underpayment or non-payment of founders or early staff. Understaffing and working folks long but unsustainable hours is common. Family members might work in the business for free. When building financial models, staffing is one category where educated guesses can be made about what it should be to support a target level of business, and so this one is less hidden, but still difficult to assess.
Making do with word-of-mouth advertising can work when a business is small, but to grow into a fundable company it will need to move beyond personal social networks and be able to develop a clientele based on its marketing & sales reach. That costs more money and changes margins on sales. Upgrades of equipment and facilities are likely in search of more efficient process, or lower risk.
Professionalization where there is currently make-do is a more subtle version that requires more attention. Bookkeeping needs to be done by a bookkeeper, not Aunt Jane. Software and technology needs to be legally purchased with regular investments for backups, replacements and upgrades. Office furniture and facilities, if cobbled together from craigslist, is a very likely expenditure as a company becomes able to afford it. Rent may be subsidized by a supportive launching business or relative.
How much growing funds are dedicated to upgrades and improvements before they’re ready to be peeled off to fund additional financing is going to vary a little bit from company to company. Does this CEO feel pinched by their 2nd hand desk or do they take pride in their own thriftiness? Is their affordable tech support person a local gem or are they having to wait for more profitability to afford better service? It does seem impossible as an outsider to assess what remains as not-yet-funded internal capacity in any given company. Instead, insisting that a company generate cashflow for a sustained period is a very tangible measure of its ability, and that CEO’s willingness, to operate at a given internal capacity level.

I’ve been deep in a small local biz (revenues < 500K annually) and it has given me a good view on some specifics of why small business is so difficult. I’ll put high on the list the challenge of not being able to afford full-time people. Instead, small business is a cobbling-together of part-time and volunteer labor. Volunteer labor is particularly important, I have yet to encounter a small business or startup that does not in some way utilize it: the founder working for no or low pay for starters! Usually a family member or good friend will pitch in, and frequently dedicated customers as well. I have yet to see any studies on this, and I was saddened to see KIRO try to make a fuss over the use of volunteer labor in a local NW business. That business was able to go back and pay everyone minimum wage, but most businesses would not be able to. It’s part of what makes a local business connected to and accountable to the community.

The part-time labor is also a challenge. Coordinating tasks and turning things around get more complicated when the designer only works on Mondays and the Project Manager for a particular project only works on Tuesdays. There’s pretty much a minimum one-week turnaround to get anything done because it takes that long for all the relevant staff members to cycle through! Need to contact a small business? Try to have a little patience when they’re not online 24/7, and realize they probably don’t have all your info and transaction history in a database at their fingertips. We’ve been trained to expect that by larger companies.

Both an upside and a downside is that jobs really are about individuals and not pure roles. In this manufacturing business, labeling is not a bottleneck because of Josh, he’s a champ. However nobody else can label as fast as he can, so should we budget for a labeling machine or should we budget for a food processor? Credit is very personal at this level as well – a startup doesn’t have the history or credit for formal bank lending. Credit is the personal credit of the founder – in a formalized way through personal guarantees or personal assets, and in an informal way by getting favors from other vendors based on personal relationship – being able to delay a payment, or borrowing equipment, or negotiating a lease.

I’m really noticing how growing a business is about steadily reducing risks – growing to hire people full time so they’re more likely to be there for you when you need them; having buffer room in the budget so unexpected expenses hit the balance sheet and not the owner’s pocket; being able to experiment more on product or placement innovation; being able to sign more contracts and get preferred pricing. Those are the efficiencies of scale – it’s about negotiating power more than just about volume, and about focused attention and commitment from stakeholders & partners that reduces frictional costs.

One way to get past many of these things quickly is to raise a bunch of equity and start operating at a higher level, but food businesses tend to be low-margin and can’t promise a return on significant equity. The steady risk-mitigation of organic growth seems to be a necessary path. Luni of the Fledge Accelerator refers to these as “earners” vs “burners”. Earners being the organic growth path, and burners being the quick equity and try to scale quickly path. A frustrating trend we’re starting to notice is that high-risk money is coming into the food/ag sector where the business models can’t justify it. In the 3-5 years it’s going to take to lose enough money that risk-takers stop flooding it in, those “burners” that get funded will distract partners and resources from the “earners” that could actually sustain and thereby starve them in the short term. It’s yet another example of how our capital funding system is broken.

I’m working with a small coffee shop on profitability and I’ve been working on managing inventory. At MBA school we learn standard inventory management methods and how important it is to track, but it’s not so easy to implement where the dollar meets the register. For starters, perpetual inventory with food is really challenging – we’d need a super detailed POS system which is expensive. I’m starting to see why my banking school instructors said they think 50K is a minimum for starting a successful business. Without technology your business can’t be very efficient, and you’re competing against businesses that do have technology. It seems the only other option is to be such a small business that one person can track most of it in their own head and have really good intuition.

That leaves me with periodic inventory, which I don’t mind except that Quickbooks seems to handle it poorly. So I’m currently in a bit of a chasm between what I’m able to do with Excel pivot tables and what we know how to do in Quickbooks.

I do see a purpose for the oft taught “reorder point” setting even in our small-inventory setting. It would help us generate the weekly shopping list. I’m also discovering an inventory challenge I didn’t learn about in business school – how to construct a minimum order. As a very small business we are challenged to meet vendors minimum orders – in some cases to order at all, in other cases to get at least a first level price break. For example: as a coffee shop we order all our flavored syrups and some other products from a single vendor. We’re running out of our most-used syrup so we need to make an order. Just ordering a case or two of that syrup doesn’t meet their minimum order, so what else should we order, and in what relative quantity? I’d like to analyze the relative consumption of goods that we order from that vendor and construct an order to the minimum amount that matches our needs. Anyone know of a quickbooks plugin (or other inventory package) that can do that?

Another challenge – like any good business we work to keep our inventory thin. Well, we don’t have to work too hard at it, we have neither the physical space nor budget to get too fat. However it seems to be a fairly common occurrence (every other week maybe?) that some item we use is not in stock when we go to purchase it. I’m learning that Cash & Carry seems to be a sort of discount supplier that will always have some variant of a product available, but it will vary: IE sometimes the napkins will be bleached and sometimes they’ll be recycled. Ditto for the paper bags of the size we like. That is a problem I’m sure larger businesses deal with as well, perhaps by padding inventory, or by getting big enough to have better relationships with their suppliers.

Another suffering of the very small business – data entry. To track all this requires hours of typing in numbers from paper receipts. Where’s the EDI interface for Cash & Carry or Costco? No wonder so few business owners do it, but without it you’re missing a key advantage. I’m beginning to think that broad support for data and analysis for small business owners would be a huge support for economic development. It amazes me what a lock QuickBooks seems to have on the market. Small suppliers don’t seem to offer much in the way of Electronic Data Interchange, but I’m just beginning to look.